I still enjoy reading The Economist even though it seems at times to be drifting away from its classical liberal roots towards a mushy center-leftist space. But the people who work there seem to be ineducable on the issue of shareholder activism. Latest case in point from the new print edition:
Shareholders own companies. Managers and directors should serve them. If the owners do not like the way their servants are performing, they have a right to do something about it. Trying to improve the way a firm is run is more constructive than the traditional “Wall Street walk”, whereby disgruntled shareholders simply sell their shares.
Wrong. Shareholders do not own corporations. Shareholders own a security representing a bundle of rights that typically includes the residual claim and a vote. See this post for a quick summary of the argument and links to other, longer posts. For the full treatment, see Stephen M. Bainbridge, The Board of Directors as Nexus of Contracts. Available at SSRN: http://ssrn.com/abstract=299743.
To be sure, part of the shareholders' contract with the corporation is the proposition that "A business corporation is organized and carried on primarily for the profit of the stockholders. The powers of the directors are to be employed for that end." Dodge v. Ford Motor Co., 204 Mich. 459, 170 N.W. 668 (1919). But that doesn't give the shareholders the "right to do something."
To encourage freedom of action on the part of directors, or to put it another way, to discourage interference with the exercise of their free and independent judgment, there has grown up what is known as the “business judgment rule.” ... “Questions of policy of management, expediency of contracts or action, adequacy of consideration, lawful appropriation of corporate funds to advance corporate interests, are left solely to their honest and unselfish decision, for their powers therein are without limitation and free from restraint, and the exercise of them for the common and general interests of the corporation may not be questioned, although the results show that what they did was unwise or inexpedient.” Bayer v. Beran, 49 N.Y.S.2d 2 (Sup.Ct.1944).
As I have noted time and again, often in response to this sort of argument from The Economist, corporate law--at least in the United States--is a system of director primacy, not one of shareholder primacy. See The New Corporate Governance in Theory and Practice, for a full defense of shareholder primacy. For those with short attention stands, here are the usual bullet points:
- Director primacy is board-centric, but shareholder wealth focused.
- Director primacy thus differs from both shareholder primacy and Stout & Blair’s team production model, not to mention the various stakeholder theories.
- I claim that the debate between these models has conflated the means and ends of corporate governance.
- For example, shareholder primacy really makes two distinct claims. As to the ends of corporate governance—in other words, the social purpose and role of the corporation—shareholder primacy claims that the duty of directors and managers is to maximize shareholder returns within the bounds of law. Director primacy concurs.
- As to the means of corporate governance—who ultimately has decision-making authority—shareholder primacy says it is—or, rather, ought to be—the shareholders. Here, director primacy says no.
- The powers of the board of directors are original and undelegated. The board of directors is the nexus of corporate contracts. The shareholders’ claim on the corporation is merely one of those contracts.
- The intersection of the power of directors to manage the corporation and their obligation to do so in the shareholders’ interest creates a variant of the principal-agent problem.
- There is a core tension between the board’s authority and the need to ensure that the board uses its authority responsibly.
- Shareholder voting rights are one of the mechanism by which directors are held to account.
- If we try to make more of shareholder voting, if we try to elevate it into a functioning part of the governance system, however, we undermine the centralization of power in the board that makes the modern public corporation possible.
- The power to review, after all, is the power to decide. Every time we increase the shareholder’s right to review board decisions, we are thus undermining the core of corporate governance by shifting the power of decision to shareholders.
- This transfer of authority from board to shareholders is undesirable in itself.
- Worse yet, the interests of activist investors likely to differ from those of shareholders as a whole
- State/local and union funds are among the most active on governance issues. They have private interests:
“progress on labor rights desired by union fund managers and enhanced political reputations for public pension fund managers.” (Romano)
- Director primacy thus calls for constraints on proposals to expand the role of shareholders in corporate governance.
The Economist disputes the claim that left-wing shareholder activism by Democrat Party-affiliated union and state/local employee pension funds is a problem, by claiming that:
... shareholder activists are unloved. From the right comes the gripe that they have the wrong motives. Last year only 1% of shareholder resolutions in America were proposed by investors “unaffiliated with organised labour or a social, religious, or public-policy purpose”, says the Manhattan Institute, a think-tank. But so what? Last year only 1% of shareholder resolutions in America were proposed by investors “unaffiliated with organised labour or a social, religious, or public-policy purpose”, says the Manhattan Institute, a think-tank. But so what? Activists prevail only when they persuade a majority of shareholders that their ideas will make money. An eco-warrior who buys a few Exxon shares and tries to stop the firm from pumping oil will not get far.
Wrong again. In the first place, people who are risk averse by definition will seek to avoid a loss even if the event in question has a positive expected value. As shareholder activism’s chief priest, Lucian Bebchuk puts it, managers “prefer not to lose votes” and, as he has put it elsewhere, “managers are risk-averse.” Accordingly, managers may still give in to blackmail by activist shareholders even where an objective analysis suggests the proposal has little chance of passage.
Second, there are several situations in which a rent-seeking proposal by activists plausibly could threaten to achieve majority support. The rent seeking institution might propose a value-increasing change, for example, which it will agree to drop in exchange for some private benefit. Bebchuk has conceded this possibility, but dismissed it on grounds that “a blackmail argument can be made not only against increasing shareholders’ power, but also against maintaining the power that shareholders currently have,” which no one proposes reducing on this account. It’s not clear, however, why the absence of proposals to further disempower shareholders necessarily provides a case for granting them extensive new powers.
Alternatively, an activist seeking private benefits could bundle a value-increasing and value-decreasing proposal in hopes of increasing the prospects of passage. The considerable attention paid to the recent anti-bundling decision invalidating Apple’s proxy notwithstanding, courts almost never invalidate proposals for being bundled. The activist also might offer side payments to other shareholders seeking their support. Vote buying, after all, is only illegal when management does it. In lieu of side payments, the activist might seek to assemble a coalition of other shareholders that would also receive private benefits, which is perhaps the most likely scenario in which an investor coalition would coalesce.
Accordingly, the majority vote requirement is an inadequate constraint on rent seeking by union and public pension funds (or other institutional investors, such as hedge funds, for that matter). To be sure, like any other agency cost, the risk that management will be willing to pay private benefits to an activist is a necessary consequence of vesting discretionary authority in the board and the officers. It does not compel the conclusion that we ought to limit the board’s power. It does, however, suggest that we ought not give investors even greater leverage to extract such benefits by further empowering them.
Finally, in response to The Economist's claim that "Empowering shareholders is a good idea," see my essay Director Primacy and Shareholder Disempowerment, which you can download here. This essay was a response to Lucian Bebchuk's article The Case for Increasing Shareholder Power, 118 Harvard Law Review 833 (2005). In that article, Bebchuk put forward a set of proposals designed to allow "shareholders to initiate and vote to adopt changes in the company's basic corporate governance arrangements."
In response, I make three principal claims. First, if shareholder empowerment were as value-enhancing as Bebchuk claims, we should observe entrepreneurs taking a company public offering such rights either through appropriate provisions in the firm?s organic documents or by lobbying state legislatures to provide such rights off the rack in the corporation code. Since we observe neither, we may reasonably conclude investors do not value these rights.
Second, invoking my director primacy model of corporate governance, I present a first principles alternative to Bebchuk's account of the place of shareholder voting in corporate governance. Specifically, I argue that the present regime of limited shareholder voting rights is the majoritarian default and therefore should be preserved as the statutory off-the-rack rule.
Finally, I suggest a number of reasons to be skeptical of Bebchuk's claim that shareholders would make effective use of his proposed regime. In particular, I argue that even institutional investors have strong incentives to remain passive.